Debasement of a Currency and Default on Public Debt are two distinctly different ways a government can fail its population. They are not the same outcome. Debasement and Default have some similar qualities, but are the result of entirely different responses to economic problems, and have extremely different consequences for the country.
Debasement of a currency is when the value of the currency is deliberately reduced by the government. It results in a “weaker” currency. Weaker in this sense means “undervalued” and also “less valuable than in the recent past”. It’s tough to pin down exactly what “weaker” means, because there isn’t some 1:1 relationship between the very vague phrase “printing money” and the value of the currency on the international markets.
In general, debasement comes from there being “too much” of the currency issued. Sometimes, if enough currency is issued by a maniacal government, the country will experience hyperinflation. Hyperinflation doesn’t happen very frequently, and seems to be almost 100% political response instead of the central bank losing control of the inflation rate.
Default on government bonds issued in the underlying currency is an entirely different process, and has a different outcome. Default on a government bond involves a country not paying the debt issued in the currency it is able to issue.
Sometimes governments place restrictions on their ability to issue currency, like we do in the United States. Here in the U.S., we can only borrow the currency from the public – with a few loopholes like the Trillion Dollar Coin. It is entirely possible for a country to be forced into default if they abide by institutional rules they have put into place. JKH has been huge on this issue – that the institutional setup defines the possible actions of the Central Bank and Treasury.
Pro Tip: Governments which place their currency in a floating peg or currency band are voluntarily giving up some of the control over their currency. So when you say “Russia defaulted”, I say “currency band”. You need to do the covered interest arbitrage equations a few dozen times before you really grok what putting a currency band does to a country. It gives the country credibility because it is linked to another, more credible currency. This credibility comes at a cost. The cost is covered in what JKH’s contingent institutional approach. A currency peg or floating peg explicitly raises the risk of default as it lowers the risk of debasement. This is the entire point of linking one currency to another currency – to change debasement risk into default risk.
The outcomes for the population for debasement and default are not the same. In default, people are not getting paid. Workers are not getting the money they are owed, and have a strong disincentive to work. In debasement, everybody wants to work today to get real world goods. Everyone with cash is trying to get rid of it as fast as possible. You are getting paid – because the boss does not want to hold onto cash anymore than the worker wants to hold onto cash.
Nor are the outcomes for debasement and default the same for bond holders. Default is a complicated process which involves lawsuits, delayed payment, and loss of principle. There is a cascading effect in the real world of lost money and unpaid debts as the lack of payments cause other payments to be missed.
These two outcomes – debasement and default – are loosely referred to as a country being broke, yet, they are very different.
So when I saw this article the other day by Karl Smith, I smacked my forehead. It’s not that he is wrong about the importance of taking care of the currency – it’s that he is conflating debasement and default.
A worthless currency does not mean “Everything in the United Kingdom and everything it’s people do is worthless to foreigners”. It just means the UK government isn’t able to issue currency. It’s entirely possible to sell assets and services for other currencies and use those currencies to purchase goods and services.
These distinctions matter. They matter when you are trying to talk about a topic like borrowing in detail, because otherwise you find yourself using words like “broke” which aren’t very precise. Broke has at least two very different meanings for a sovereign, and getting these meanings correct and clear in your mind is part of the way the world becomes a better place.
The path to debasement and the path to default are different paths. And our world is far more exposed to one path than another path right now. We aren’t exposed to very much to the debasement path – so I don’t know why Karl is talking about the UK currency being worthless on the international markets, as this would mean a massive debasement.
Here in the United States, we have very low inflation, and yet politicians just threatened a default on U.S. government debt. We’re far more exposed to default here in the U.S. In Europe, we have countries like Greece, Portugal, and Cyprus close to default, but not much inflation or debasement of the euro currency.
Update 10-25-2013: Debasement must have been in the noosphere. JP Koning (via Mike Sproul) wrote up something really sharp on debasement. There are physical reasons why debasement could be preferable to keeping the quantity of metal to nominal value constant.